BIS Working Papers No 677 Macroeconomic implications of financial imperfections: a survey by Stijn Claessens and M Ayhan Kose Monetary and Economic Department November 2017 JEL classification: D53, E21, E32, E44, E51, F36, F44, F65, G01, G10, G12, G14, G15, G21 Keywords: asset prices, balance sheets, credit, financial accelerator, financial intermediation, financial linkages, international linkages, leverage, liquidity, macrofinancial linkages, output, real-financial linkages BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2017. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) Macroeconomic implications of financial imperfections: a survey Stijn Claessens and M. Ayhan Kose Abstract This paper surveys the theoretical and empirical literature on the macroeconomic implications of financial imperfections. It focuses on two major channels through which financial imperfections can affect macroeconomic outcomes. The first channel, which operates through the demand side of finance and is captured by financial accelerator-type mechanisms, describes how changes in borrowers’ balance sheets can affect their access to finance and thereby amplify and propagate economic and financial shocks. The second channel, which is associated with the supply side of finance, emphasises the implications of changes in financial intermediaries’ balance sheets for the supply of credit, liquidity and asset prices, and, consequently, for macroeconomic outcomes. These channels have been shown to be important in explaining the linkages between the real economy and the financial sector. That said, many questions remain. JEL classifications: D53, E21, E32, E44, E51, F36, F44, F65, G01, G10, G12, G14, G15, G21 Keywords: asset prices, balance sheets, credit, financial accelerator, financial intermediation, financial linkages, international linkages, leverage, liquidity, macrofinancial linkages, output, real-financial linkages Claessens (Monetary and Economic Department, Bank for International Settlements; CEPR; [email protected]); Kose (Development Prospects Group, World Bank; Brookings Institution; CEPR; CAMA; [email protected]). We are grateful to Olivier Blanchard for his helpful comments at the early stages of this project of surveying the literature on macrofinancial linkages when we were with the Research Department of the International Monetary Fund. This paper has a companion, “Asset prices and macroeconomic outcomes: a survey,” BIS Working Paper no. 676. We would like to thank Boragan Aruoba, Claudio Borio, Menzie Chinn, Ergys Islamaj, Jaime de Jesus Filho, Raju Huidrom, Atsushi Kawamoto, Seong Tae Kim, Grace Li, Raoul Minetti, Ezgi Ozturk, Eswar Prasad, Lucio Sarno, Hyun Song Shin, Kenneth Singleton, Naotaka Sugawara, Hui Tong, Kamil Yilmaz, Kei-Mu Yi, Boyang Zhang, Tianli Zhao, and many colleagues and participants at seminars and conferences for useful comments and inputs. Miyoko Asai, Ishita Dugar and Xinghao Gong provided excellent research assistance. Mark Felsenthal, Sonja Fritz, Krista Hughes, Serge Jeanneau, Graeme Littler, Tracey Lookadoo, and Rosalie Singson provided outstanding editorial help. The views expressed in this paper are those of the authors and do not necessarily represent those of the institutions they are affiliated with or have been affiliated with. WP677 Macroeconomic implications of financial imperfections: a survey i “…They [economists] turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets – especially financial markets – that can cause the economy’s operating system to undergo sudden, unpredictable crashes …” Paul Krugman (2009a) ““Hello, Paul, where have you been for the last 30 years?”… Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors... The long literature on financial crises and banking … has also been doing exactly the same….” John H. Cochrane (2011) “I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not…” Narayana Kocherlakota (2010) “… What does concern me of my discipline, however, is that its current core – by which I mainly mean the so-called dynamic stochastic general equilibrium (DSGE) approach – has become so mesmerized with its own internal logic… This is dangerous for both methodological and policy reasons… To be fair to our field, an enormous amount of work at the intersection of macroeconomics and corporate finance has been chasing many of the issues that played a central role during the current crisis… However, much of this literature belongs to the periphery of macroeconomics rather than to its core…” Ricardo Caballero (2010) “One can safely argue that there is a hole in our knowledge of macro financial interactions; one might also argue more controversially that economists have filled this hole with rocks as opposed to diamonds; but it is harder to argue that the hole is empty.” Ricardo Reis (2017) “The financial crisis … made it clear that the basic model, and even its DSGE cousins, had other serious problems, that the financial sector was much more central to macroeconomics than had been assumed...” Olivier Blanchard (2017a) WP677 Macroeconomic implications of financial imperfections: a survey iii Table of contents 1. Introduction ....................................................................................................................................... 1 2. Financial imperfections: the demand side ............................................................................. 6 A. Basic mechanisms ................................................................................................................. 6 B. Empirical evidence ................................................................................................................ 8 3. Financial imperfections in general equilibrium ................................................................. 11 A. The financial accelerator .................................................................................................. 12 B. Quantitative importance of the financial accelerator ........................................... 13 4. Financial market imperfections in open economies ........................................................ 17 5. Financial imperfections: the supply side .............................................................................. 20 A. Bank lending channel ........................................................................................................ 20 B. Bank capital channel .......................................................................................................... 23 C. Leverage and liquidity channels .................................................................................... 24 6. Evidence relating to the supply side channels ................................................................... 26 A. Bank lending channel ........................................................................................................ 26 B. Bank capital channel .......................................................................................................... 28 C. Leverage and liquidity channels .................................................................................... 29 7. Aggregate macrofinancial linkages ........................................................................................ 32 A. Business and financial cycles .......................................................................................... 33 B. Linkages between business and financial cycles .................................................... 35 8. Conclusions ...................................................................................................................................... 38 A summary ...................................................................................................................................... 38 What next? ...................................................................................................................................... 39 Appendix I. Research on macrofinancial linkages: a brief history ...................................... 44 Appendix II. Financial accelerator mechanisms ......................................................................... 50 Appendix III. Understanding liquidity and leverage cycles ................................................... 53 Appendix IV. Linkages between business and financial cycles: an overview of empirical studies ........................................................................................................................... 55 Credit market cycles and business